Commentary: Why Roth may be the better option for younger investors
For those in their 20s, retirement is probably not at the front of your mind. Some may be working on paying down their student loans. Others may be focusing their savings toward trying to put together enough for a down payment on a home. But we e...
For those in their 20s, retirement is probably not at the front of your mind.
Some may be working on paying down their student loans. Others may be focusing their savings toward trying to put together enough for a down payment on a home. But we encourage you to consider putting some money away for retirement, especially if your employer has a company-sponsored plan and a matching contribution.
For those who are able to contribute money to a retirement account, you may have to choose between a traditional option and a Roth option. So how should younger investors allocate their savings for retirement?
We were posed that question on our radio show recently: Do you recommend those in their 20s utilize the traditional or the Roth option inside of a 401(k) or IRA?
Before analyzing the two options, those in their 20s who are saving money for retirement deserve to be congratulated! We like to say that young investors are "rich in youth," meaning they have the ability to take advantage of compounding interest which, over several decades, can have dramatic effects on your nest egg when you enter retirement.
This decision largely comes down to choosing when you want your money to be taxed. With the traditional option, the money is contributed on a pre-tax basis, meaning you get a tax deduction on the contribution. When you take distributions, presumably in retirement, that money will be taxed as regular income. With the Roth, you're contributing dollars that have already been taxed, but when you make your qualified distributions in retirement, those dollars will be tax-free.
Generally speaking, there isn't a 'better' or 'worse' option, but for younger workers, the Roth is likely to be a better choice for two key reasons.
First, the Roth tends to be a bigger boon for long-term investments, and someone in their 20s putting money into a 401(k) is the epitome of a long-term investor. To illustrate why, let's pretend you're putting $1 into a traditional plan while in the 25 percent tax bracket. In this scenario, you save $.25 on taxes immediately whereas with the Roth, there is no immediate tax savings.
Now, let's look ahead a few years and assume the original $1 contribution has grown to $10 in retirement. If you're still in the 25 percent bracket, you will have to pay a tax of $2.50 on your tax-deferred withdrawal; the $10 in the Roth would have no tax bill. Over the long term, as a general rule, you'll probably net more money via the Roth than you will with the traditional. Keep in mind, this example is just a hypothetical, but it does a great job of illustrating the potential power of tax-free earning and distributions a Roth provides.
The other reason that younger workers are likely to see a greater benefit from a Roth is that those in their 20s are generally just beginning their careers, meaning their incomes are likely lower now than they will be 10, 20 or 30 years from now. Typically, it's most advantageous to use a Roth when your income is at its lowest and to use the traditional option when your income is higher, as this maximizes the benefits from the tax deduction.
Of course, there are plenty of good reasons why those in their 20s may want to contribute at least a portion of their retirement savings to the tax-deferred account. For example, if you are close to the threshold of a higher tax bracket, you may find significant value in contributing enough to the tax-deferred plan to keep yourself in the lower bracket.
The specific amounts you should contribute to the tax-deferred or Roth plan are unique to each individual, and the final answer depends upon your financial situation. The important thing is that, regardless of the tax decision made, you're saving at a young age. This is the perhaps the single best thing someone in their 20s can do to set themselves on the path to financial success.
By Bruce Helmer and Peg Webb, financial advisers at Wealth Enhancement Group and co-hosts of "Your Money" on KLKS 100.1 FM on Sunday mornings. Email Bruce and Peg at email@example.com . Securities offered through LPL Financial, member FINRA/SIPC. Advisory services offered through Wealth Enhancement Advisory Services, LLC, a registered investment adviser. Wealth Enhancement Group and Wealth Enhancement Advisory Services are separate entities from LPL Financial.